Solution to
Le Serpent - An International Finance Case Study

by Ian H. GiddyStern School of Business, New York University

Overview

This case, Le Serpent, concerns the role of the Italian lira in the Exchange Rate Mechanism (ERM) and the causes and consequences of the devaluation of a currency in this system. The most important issues include:

The meaning of "The Snake" in the European Monetary System (EMS),

The impact of a devaluation upon different sectors of the economy, and on a company, in terms of costs, prices and level of sales, and

The impact of a devaluation upon interest rates.

Objectives

The case is a good introduction to international financial management because it reviews exchange rates and the risks they pose to the operations of an international business. The case introduces a discussion of the benefits and costs of fixed exchange rates as envisioned in Europe's plan for Economic and Monetary Union (EMU).

Analysis

The analysis begins with a review of the European system of pegged exchange rates. Then it discusses the Italian lira in this context. It ends with an analysis of the benefits and costs of monetary union in Europe.

1. The European Monetary System (EMS)

"The Snake" is a term sometimes used informally to describe the agreement whereby most members of the European Union maintain their currencies within a narrow trading band. The limits for allowable exchange rate movement imposed by the trading band maintain "order" in international trade. Most currencies can move within 15% above or below a central rate; Germany, the Netherlands and Austria (2.25%) are exceptions at present (1996). Some members of the European Union, notably the United Kingdom, have dropped out of the ERM altogether. When an exchange rate pushes against the allowable limits of its float, both countries involved are supposed to take action to correct the situation. Should one country's currency gain or loose value against all the others, it would be up to that country to correct the situation by devaluing or revaluing its currency. In practice, the system tends to be asymmetric, with the country at the bottom of its band having to consider the devaluation of its currency.

The snake is the basis of the system of pegged exchange rates known as the European Rate Mechanism (ERM). The ERM consists of the members of the European Union (except Greece and Portugal) which agree to actively manage their currencies in order to maintain the parities of the European Monetary System (EMS), a broader mechanism which also sets the central rates of exchange and oversees the European Currency Unit (ECU).

2. The Italian Lira

In the case, Exhibit 1 shows that the lira is near the limit of its allowable divergence from the central rate. The expectation of a currency devaluation increases as the limit draws near and official reserves are exhausted.

Italy has several choices. It could raise interest rates to stimulate demand for the lira, but this would increase the interest to be paid on public-sector debt (and the size of the debt). In the longer run, it could curtail public spending, widen the tax base, enforce rules against tax evasion and cut back on subsidies and pensions; but these measures would make the government unpopular. It could use its own reserves (or request use of the reserves of a bilateral country such as Germany) to support the lira, but the reserves are finite and their use may be in vain when foreign exchange speculators are attacking a currency. It could devalue the lira (as it actually did in September, 1992; more specifically, it temporarily dropped out of the ERM).

The high official interest rate is a reflection of the growth of public-sector debt used to finance massive budget deficits. Further, without a high interest rate, Italy is threatened by a run on its currency.

3. The Impact in Italy of Devaluation of the Lira on Costs, Prices and Sales

The impact of devaluation of the lira will vary according to the sector of the Italian economy. A few examples will demonstrate some of the effects.

Small local bakery. Local merchants who both buy and sell domestically and have little foreign competition will not be affected by the devaluation.

District outlet for imported wine. A devaluation will cause imports to be more expensive (in terms of Italian lira). A seller of imports with domestic substitutes will be adversely affected because the prices of local competitors tend to remain unchanged if their costs are unaffected.

Exporter of Italian bicycles. If the bicycles are made from domestic materials and labor, then the exporter will gain from the devaluation. An unchanged price in a foreign currency will yield more lira.

Company which assembles foreign components for sale in foreign markets. In domestic currency, imports will be more expensive and exports will yield a higher price. The company will benefit to the extent that Italian wages become lower than those paid by foreign competitors.

To summarize, the impact of a devaluation on an industrial sector is determined by (1) raw materials imported, (2) products exported, (3) competitors with imported goods, (4) competitors with domestically produced goods, and (5) competitors facing a similar structure of costs and prices.

4. The Impact in Italy of Devaluation on Interest Rates

The expectation of devaluation accounts for the Eurocurrency interest rate which is higher than the official interest rate. Investors will want to borrow lira before the devaluation, exchange them into another currency such as francs to buy financial assets, and then change them back into lira after the devaluation. This activity will cause Italian interest rates (and the forward exchange rate premium) to increase to about as much as the expected devaluation. After devaluation, the nominal interest rate should move closer to the nominal interest rates of other countries in the ERM.

5. Benefits and Costs of Fixed Exchange Rates in the ERM

The benefit of the ERM is that trade is enhanced when foreign exchange rates among trading partners are stable. Foreign exchange rate risk is a barrier to the movement of goods and capital across national borders.

The cost occurs because exchange rates are neither fixed nor floating in the ERM. Rather, they fluctuate within a band and then jump to a new level after realignment. If the rate of interest (and inflation) is higher in Italy than in France and the exchange rate is fixed, then a French investor will buy Italian financial assets. Only the same nominal interest (and inflation) rates will make an investor indifferent to the currency of his investment. When countries are following diverse monetary policies, say expansion versus restraint, interest (and inflation) rates will differ. Speculators will seek the highest nominal interest rates with little exchange-rate risk to the extent that currencies are locked together. In time a realignment becomes inevitable, and the nominal interest rate of the country with the weak currency must be raised still higher to postpone it. In the meantime, central banks support the weak currency by using reserves of hard currencies to buy it, and speculators gain. Controls on the movement of capital and uncertainty about the timing of a devaluation dampen this tendency to some extent.